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Using 'Alpha' to Pick the Best Mutual Funds

Stan LuxenbergSpecial to TheStreet

NEW YORK (TheStreet) -- Plenty of investors are abandoning actively managed mutual funds and shifting to index funds.
Investors figure that it's simply too hard to pick active winners. Just because a fund delivered double-digit returns in the past does not mean that it will repeat the performance in the future, their thinking goes.
But a growing number of research studies indicates that there are ways to pick winning actively managed funds.
The researchers suggest following risk-adjusted performance as measured by an indicator known as "alpha." By considering alpha, investors can compare a fund to its benchmark.
Say a fund takes as much risk as its benchmark, the S&P 500. While the S&P returns 10%, the fund returns 11%. The fund is said to have an alpha of 1.0. If the fund returns 9%, then it has an alpha of -1.0.
Alpha is particularly important because it tends to be persistent. If a fund had a positive alpha in the past, it is likely to have a positive alpha in the future.
Investors should pick funds with high alphas and below-average expenses, says a study by W. Van Harlow, director of research of Putnam Institute, which is funded by Putnam Investments, a fund company.
Van Harlow found that funds with high alphas have a 60% chance of outperforming peers in the future on a risk-adjusted basis.
Not many funds deliver high alphas. The average large blend fund has an alpha of -1.25. Clearly investors should steer away from average funds. But there is a small number of funds that have delivered high alphas over long periods of time.
Among the top performers are Weitz Partners III Opportunity Investor , which has an alpha of 9.68, Sequoia with 6.25, and Hennessy Focus 30 with 4.34.
Sequoia has a long track record for success. During the past decade, the fund returned 6.3% annually, outpacing the S&P 500 by 2 percentage points while taking much less risk than the benchmark as measured by an indicator called beta.
Sequoia has achieved its results by buying dominant companies with strong balance sheets and rich cash flows. Holdings have enduring competitive advantages. The portfolio includes such rock-solid companies as Wal-Mart Stores and International Business Machines .
The high-quality holdings have enabled the fund to excel in downturns. During the collapse of 2008, Sequoia outdid the S&P 500 by 10 percentage points and surpassed 97% of its large blend peers. Dedicated disciples of Warren Buffett, the portfolio managers rarely trade. Some holdings have been in the portfolio for more than 10 years.
Weitz Partners III Opportunity has delivered high returns while taking less risk than the S&P 500. During the past five years, the fund has returned 3.5% annually, outdoing 95% of peers.
Portfolio manager Wally Weitz looks for undervalued companies with strong cash flows. "We like good companies that produce more cash than they need to run their businesses," he says.
A die-hard value investor, Weitz aims to buy stocks when they are out of favor. In recent years, he has loaded up on unloved blue-chip technology companies, such as Microsoft and Dell .
To control risk, Weitz sometimes takes short positions in exchange-traded funds, aiming to profit if stocks drop. He seeks to short segments of the market that appear rich. The fund is currently short 14% of assets, including a short position in SPDR S&P 500 . The short positions helped to lower the volatility of the fund in the last year when markets bounced up and down.
An unusual fund with a high alpha is Hennessy Focus 30.
Portfolio manager Neil Hennessy follows a rigid formula. He starts by assembling a list of mid-cap stocks that have price-to-sales ratios of less than 1.5 and have reported annual earnings gains in the past year.
Of that group, he takes the 30 stocks with the greatest share appreciation in the past year. The aim is to identify stocks with modest prices that are beginning to climb.
The process has resulted in a portfolio with above-average returns and below-average risk. During the past five years, the fund has returned 3.1% annually, outdoing 63% of peers.
The portfolio is currently loaded with discount retailers, including Family Dollar Stores and Ross Stores . "Consumers have not stopped spending, but they are focusing on necessities," says Hennessy.
Hennessy's formula does not work every year. During the roaring rally of 2009, the fund finished in the bottom half of the standings. But the approach has produced below-average risk scores. That has enabled the fund to score strong risk-adjusted returns.

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